Estate Planning Alert - Implications of 2010 Tax Law Changes

Friday, February 4 2011 4:34 PM

On December 17 of last year, President Obama signed into law the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (“the Act”). The Act, which is best known for extending the Bush Administration tax cuts on the income tax side, also created a new transfer tax regime, with implications for those who have substantial estates.

Overview of the Act

The following are highlights of the new law, which will “sunset” January 1, 2013.

The estate tax exemption amount (technically referred to as the applicable exclusion amount) is $5,000,000. The estate tax is imposed at a rate of 35% on the value of the estate in excess of the exemption. The generation-skipping transfer tax is reinstated with an exemption of $5,000,000 and a rate of 35%. These exemption amounts will be adjusted for inflation in 2012.

“Portability” under the new law allows spouses to use both of their exemptions to create, in effect, a combined exemption of $10,000,000, even without resort to the traditional bypass or “family” trust.

The lifetime gift tax exemption amount has been raised from $1,000,000 to $5,000,000, and annual exclusion gifts (currently $13,000 per donee per year) remain in place. As before, lifetime gifts in excess of the gift tax annual exclusion and other gift tax exclusions are “adjusted taxable gifts” and will use up part of the $5,000,000 which is available at death.

The new law is partially retroactive to January 1, 2010. The estates of decedents who died in 2010 are afforded the opportunity to elect out of the estate tax by accepting the limited income tax basis step-up adjustments that were available in 2010.

The new legislation has already generated widespread interest, and existing plans are being reviewed in light of the new laws.

Planning Implications

Planning for Taxes Remains Important. While there is every reason for individuals whose estates are less than $5,000,000 ($10,000,000, combined, for married couples) to feel a sense of relief and a new freedom in connection with their estate planning, most individuals whose estates were large enough to justify estate tax planning in prior years should continue to plan in light of possible estate, gift and generation-skipping consequences to their heirs.

The generous exemptions created by the Act are effective only for 2011 and 2012. During the Congressional debates, some contended that the extension of the Bush Administration tax cuts (particularly on the income tax side) should be made “permanent.” But even if the sunset provisions of the Act had been eliminated, there could have been no guarantee that the transfer tax provisions of the Act would continue far enough into the future to benefit a current client with a normal life expectancy. There is simply no such thing as a permanent change to the tax law, and no one can know what the tax scheme will be at the time of a particular person’s death. This fact suggests to us that our clients will continue to be best served by plans that are both flexible and conservative—plans that do not place too great a reliance upon the provisions of the Act.

Is the Day of the Family Trust Over? For many decades, the basic tax plan for married couples with substantial assets involved the creation of a tax bypass trust or “family” trust at the death of the first spouse. That trust would receive the assets of the first deceased spouse up to the tax threshold, and use them for the survivor’s benefit. By limiting the survivor’s access to the assets, the survivor’s estate would not include the assets of the family trust at the survivor’s death.

Now, with higher tax exemptions in place, there may be a strong tendency on the part of some married couples whose estates are significantly under $10,000,000 to assume that the “coast is clear” to simplify tax-oriented plans into simpler “I love you” plans. While we are sympathetic to the desire to simplify plans and reduce or eliminate the tax features that have complicated planning documents, we believe it is incumbent upon us, before recommending the adoption of an all-to-spouse plan, to discuss considerations such as the following with our clients:

The tax exemption that must be planned for is not necessarily the current tax exemption, but rather the tax exemption that is in effect at the time of the surviving spouse’s death, which could be significantly reduced below the current level.

There may be significant advantages beyond estate tax avoidance in creating a family trust at the first death. These could include creditor protection and protection from remarriage situations. There could also be an income tax advantage to creating a family trust which allows income to be distributed to family members who may be in lower tax brackets.

In many cases, it may be advisable to plan for the creation of a family trust at the first death, but give the surviving spouse the election of funding the family trust by means of a qualified disclaimer. That approach would permit the surviving spouse to decide at a future vantage point (within nine months after the first spouse’s death) whether to create the family trust.

Using Lifetime Gifts to Advantage. Lifetime gifts can have substantial tax benefits. High net worth individuals have a new opportunity to make large gifts with little or no gift tax since the gift tax exemption has increased to $5,000,000. Because there is no guarantee that the increased lifetime gift and generation-skipping tax exemption amounts will be extended beyond 2012, individuals with sizeable estates may wish to consider making substantial gifts in 2011 or 2012. While there have been proposals to change the law to reduce or eliminate valuation discounts, interests in entities such as family limited partnerships can still be discounted for gift tax purposes. Use of techniques such as grantor retained interest trusts, charitable lead trusts, installment sales and self-cancelling notes are particularly attractive under the current low interest rates.

Making the Most of the Opportunities

The most important message that we wish to convey is that the need for tax planning still exists, and that there are advantages to planning proactively.